As we entered 2010, global equity markets had already staged an impressive rally from their March lows. With the Greek debt crisis becoming front page news, US equities, and risk-oriented assets in general, declined in January. However, despite Europe’s sovereign debt crisis, domestic equity markets regained their footing in February and rallied through the third week in April before declining over the last week of the month. By the end of April, domestic equities had registered gains in 12 of the previous 14 months and none of the declines from the highs were significant enough to truly be considered a correction. Through the third week in April, three of our four domestic equity benchmarks had posted double-digit year-to-date returns. Small cap issues had more than doubled from their bottom the previous March and large cap stocks had nearly done so (Charts 1 and 2).
While the recovery began sooner than we had expected and has been broader and deeper than anticipated, surely US equities were not only ripe for, but truly in need of a correction. Continued appreciation at the pace set over the 14 months through April would have left US equities massively overvalued by the end of 2010. Yet declining equity prices, mixed economic data, the European debt crisis, and fresh memories of the market’s collapse has left investors shaken and concerned that a new bear market is upon us.
The global economy, capital markets, and investor psyches all remain fragile. We have continually cautioned that nearly all developed economies face significant structural challenges in exiting the credit crisis and the global recession it helped spawn. These challenges are likely to result in an uneven recovery and choppy markets. As a result, investors may be prone to expect the worst whenever downside volatility rears its head.
Yet evidence suggests that domestic equity markets are experiencing a correction rather than a new (or continuing, depending on your point of view) bear market. Given the duration and size of the rally from the market’s nadir, a correction was likely. FMR (Fidelity Management and Research) calculates that, prior to the current downturn, there have been 20 corrections in bull markets since 1928. In identifying these corrections, Fidelity defined bull and bear markets as 20% increases and decreases, respectively, in the price performance of the S&P 500. They defined corrections as declines that reached at least 10% but were less than 20%. Of the 11 corrections that represented the initial corrections in bull markets, most began about 18 months after the beginning of the bull run and they typically occurred after an initial rally of less than 60% (Table 1).
While the recent downturn has occurred a bit earlier than the typical initial correction in a bull market, the gains in the initial rally have been larger than those typically experienced in the first stage of a bull market. With the correction appearing to have bottomed on June 7th, its duration was modestly shorter and its magnitude modestly larger than the medians of the previous 20 corrections (both initial and subsequent) identified by Fidelity over the last 82 years (Table 2). In short, recent market activity has been in-line with historical experience of a bull market experiencing its first correction.
While the above information is statistically comforting and provides us with historical guideposts, it is important to remember that each market cycle has its own unique characteristics and drivers. No two bull or bear markets are exactly alike. The synchronous nature of the global downturn was unusual. The fiscal imbalances in the developed world, global trade imbalances, and the growing stability and importance of emerging economies all make the current market environment different than those that have preceded it.
Yet looking behind the historical record to the earnings performance of the S&P 500 also suggests that we are experiencing a correction rather than a descent into bear territory. Data from Smith Group Asset Management indicates that S&P 500 companies once again soundly beat consensus earnings estimates during the 1st quarter. With 93% of the benchmark’s companies having reported, the vast majority had beaten consensus sales and revenue expectations. Undoubtedly, comparisons with the 1st quarter of 2009 were exceptionally easy, but absolute earnings growth has been very attractive and continues to outstrip expectations (Table 3). Of 10 economic sectors in the benchmark, only the telecom and energy sectors suffered earnings declines from the 1st quarter of 2009. The other eight sectors experienced double-digit earnings growth, led by the consumer discretionary and technology sectors, which posted gains of 48.90% and 50.80%, respectively, over the 1st quarter of 2009. From quarter-end through June 16, analysts increased their 2nd quarter earnings estimates for the S&P 500 by 3.32% while raising their full year estimates for 2010 by 4.58%.
Additionally, companies are raising dividends; evidence of their confidence in the continuation of the recovery in their earnings. Through May, more than 500 publicly traded companies either increased or resumed their dividends while fewer than 100 decreased or omitted them (Chart 3). While the number of companies increasing dividends through May of this year was about half as many as during the same period in 2007, this represents an increase of nearly 58% over the first five months of 2009.
Of the 11 initial corrections in bull markets identified by Fidelity between 1928 and 2002, only two began after larger initial rallies. While the initial rally was a bit shorter in duration than the median, in four instances the initial correction occurred after shorter rallies. In short, a correction of the magnitude and duration we have experienced coming at this juncture in a bull market is a normal occurrence. Meanwhile, earnings continue to outstrip analysts expectations and dividend increases are far outstripping reductions. All of this suggests that we have just experienced the initial correction in a bull market, not the resumption of a bear market.
After peaking on April 23rd, US equity markets fell nearly 14% over the subsequent six weeks. Investors, still nursing their wounds from the worst bear market in 35 years, have understandably been shaken. However, investors should learn to embrace corrections as an important characteristic of a healthy bull market. Corrections allow markets to consolidate their gains and reduce the risk that prices rise far ahead of fundamentals.
